Inequality: Basic concepts and trends

1. Inequality: Basic concepts and trends Session I March 13, 2008 Branko Milanovic

2. 1. Global: Inequality between countries and individuals

3. Three concepts of inequality defined Concept 1 inequality Concept 2 inequality Concept 3 (global) inequalty

4. Inequality, 1950-2005:The mother of all inequality disputes 0.7 Global inequality (Concept 3) 0.6 Weighted international inequalty Gini coefficient (Concept 2) Weighted international inequality without China 0.5 Unweighted international inequality (Concept 1) 0.4 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 1950 1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984

5. Global inequality (distribution of persons by $PPP or US$ income per capita)

6. How big is a Gini of 64-66?

7. First order positional dominance:year 2002 100 Germany 80 urban China 60 Sri Lanka Brazil percentile of world income distribution rural India 40 20 0 0 5 10 15 20 country ventile twoway (line Y02_c group if contcod=="BRA") (line Y02_c group if contcod=="IDN-R") (line Y02_c group if contcod=="DEU") (line Y02_c group if contcod=="LKA") (line Y02_c group if contcod=="CHN-U"), legend(off) xtitle(country vent> ile) ytitle(percentile of world income distribution) text(90 3 "Germany") text(62 5 "urban China") text(50 6 "Brazi l") text(52 12 "Sri Lanka") text(40 18 "rural India")

8. 2. Relationship between income and inequality: the rise and fall of the Kuznets hypothesis

9. Kuznets curve (defined in 1955) • As income increases, inequality at first goes up and then declines • “It seems plausible to assume that in the process of growth, the earlier periods are characterized by a balance of counteracting forces that may have widened the inequality in the size distribution of total income for a while because of the rapid growth of the non-A [non-agricultural] sector and wider inequality within it. It is even more plausible to argue that the recent narrowing in income inequality observed in the developed countries was due to a combination of the narrowing inter-sectoral inequalities in product per worker, the decline in the share of property incomes in total incomes of households, and the institutional changes that reflect decisions concerning social security and full employment."

10. Kuznets curve: history • Evidence for Kuznets curve in cross-sectional data analyzed in the 1970s, 1980s (Paukert, Lecaillon, Koeble & Thomas) • More than 90% of pooled time-series and cross-sectional Gini variability is due to differences between countries => factors that determine country inequality are stable • Elusive evidence in time-series (Oshima) • Modifications of the Kuznets curve: “strong” and “weak” formulations

11. General formulation (used by Ahluwalia 1976) • We expect β1>0 and β2<0 • Control variables include socialist dummy, government transfers, share of state sector employment, openness, age structure of population (Milanovic 1994; Williamson and Higgins 1999)

12. A simple quadratic relationship between Gini and GDI per capita, 1950-2000

13. No controls; a weak inverted U relationship (more than 1000 Gini obs) • Huge variability in inequality; R2 only 0.08 • The upward sloping part of the curve particularly hard to discern • Turning point quite unstable; here about $PPP 2,000 (level of Senegal or Zimbabwe) • Gradual disenchantment with the hypothesis

14. Credit market imperfections • Poor households do not invest in human K even if the returns are high; they invest in subsistence-related types of investment • Indivisibilities: minimum threshold of K needed for investment; convex returns • Societies with these problems both more unequal and wasteful in terms of human and capital resources • Example of win-win strategy (inequality&growth) • Solutions: asset redistribution, no school fees, deeper capital markets, micro finance

15. Credit constraint, education, democracy (Li, Squire & Zhou)

16. Long-run studies using income and inheritance tax data (Picketty et al.): France 1901-98 • Secular decline in inequality • Due to the declining share of top 1% • Due to the decreasing importance of large capital income • Due to progressive taxation and progressive (and high) inheritance taxes • Produces no effect on average K stock but truncates large K holdings (lower concentration of capital income)

17. Story for the US (Piketty & Sanz) • Top K incomes decreased during the Depression and WW2 and never recovered (top estates still lower in real terms than around 1900) • Total K income did not decrease; its concentration did • Change in factoral income composition among the top 1%; no longer mostly capitalists but salaried workers. Δ more pronounced in the US than in France • Conclusion: No spontaneous decline in inequality. Role of depression, wars and progressive taxation. Policy and politics matter the most.

18. Recent findings • A number of similar studies for developed countries reaches the same conclusion: a U-shaped inequality in the 20th century in English-speaking countries (UK: Atkinson 03; Netherlands: Atkinson & Salvedra 03; Italy: Brandolini) • But also for India: Banerji and Piketty 2005 • Long L shaped curve for the rest of developed countries

19. Source: Piketty and Saez (2006)

20. Source: Piketty and Saez (2006)

21. Source: Piketty and Saez (2006)

22. But this finding crucially depends on strong ρ btw. Gini and top income share; while true among recent data, not true historically! twoway scatter top_percent gini if sample==1, msize(vlarge) mlabel( country) Source: Milanovic, Williamson and Lindert (2007)

23. 3. How inequality might affect growth

24. Political mechanism Greater inequality in factor income=> Relatively poor μ voter=> Chooses relatively high tax rate Economic mechanism High redistribution and distorsionary effect of taxes => Lower growth rate Channel 1: The median voter hypothesis

26. Extent of redistribution = = fct (inequality in market income) • Hypothesis 1. More market-unequal countries redistribute more (using two definitions of market income) • Hypothesis 2. If countries do redistribute more, is the mechanism through which it happens, the medum voter hypothesis?

27. Redistribution is greater if the market income share of the poor is less Source: Milanovic 2000

28. But we cannot show that the middle deciles gains more if market inequality high Source: Milanovic 2000

29. Political mechanism Greater inequality creates cleavages => They are particularly strong if coincide with ethnic differences (high horizontal inequality)=> Insecure property rights Economic mechanism Insecure property rights => Lower growth rate Channel 2: Inequality and property rights

30. Inequality and property rights(Keefer & Knack) Dependent variable: Property rights: ICRG measure 1986-95. Ranges from 0 to 50.

31. Excursus: the reverse link and the reverse sign: greater protection of property rights increases inequality

32. Greater protection of property rights increases inequality • The rich elite is also politically powerful and protects its economic assets • The effect is mitigated by the introduction of democracy • => The negative effect of property rights protection is particularly strong in low-democracy environments • But the regression does not include an income term (results based on Savoia and Easaw, 2007)

33. Channel 3. Inequality caused by “morally irrelevant” characteristics • Inequalities which are independent of individual effort, entrepreneurship or luck • Wasteful” (vs. instrumental or “useful”) inequality • Examples: education, health, opportunity to better oneself economically, to have a political voice • Horizontal inequalities between ethnic/religious groups, education levels, socio-economic categories, geographical areas

34. Explaining one’s position in the world income distribution(dependent variable: percentile in world income distribution)

35. Assumed ρ’s for different parts of the world Also a super-optimistic: ρ=0.2 for all; and super-pessimistic: ρ=0.9 for all. ρ’s based on literature review.

36. Explaining one’s position in the world income distribution(dependent variable: percentile in world income distribution)

37. Now, circuscumstances (country + parents’ income class) explain between 76 percent (if world is fairly income-mobile within countries) and 83 percent (if there is less social mobility) of variability in global income position • Coefficient on country mean income remains about the same; coefficient on parental income position (as expected) higher if there is less income mobility

38. As a proxy, WDR06 looks at the contribution of horizontal inequalities to total inequality, or total “feasible between- inequality” • Up to 40-45% of “feasible inequality” explained by education differences • Inequality traps and the interaction between political and economic power

39. Inequality measurement axioms • 1. If all incomes are multiplied by a constant (Y1=Y*C), inequality does not change. • 2. Increase of all incomes by a constant (Y1=Y+C), reduces inequality (follows from 1). New distribution is Lorenz-superior. • 3. If number of recipients is multiplied (at each income level) by a constant, inequality does not change • 4. Progressive transfer (which does not change the rankings of individuals) reduces inequality (Dalton’s axiom). (Dalton improvement = income of the poor ↑ by at least as much as income of the rich goes down. “Leakages” may prevent Dalton improvement.) • 5. Symmetry or anonymity: if two people swap positions, inequality does not change. • 6. Inequality measure lies in [0,1] domain.

40. Measures of inequalityDesirable properties and how different measures satisfy them.